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cfin ch 8...
| Question | Answer |
|---|---|
| Need way to compare investment returns when risks are different… | Use Standard deviation- measure of spread (dispersion) about mean (evaluating risk) |
| Larger σi is associated with | with a wider probability distribution of returns |
| Total Risk of portfolio= | Firm-specific risk + Market Risk |
| Firm-specific risk | portion of a security’s risk that can be eliminated through proper diversification (diversifiable or unsystematic risk) |
| Market risk | portion of a security’s risk that cannot be eliminated through diversification (non-diversifiable or systematic risk) |
| what does it mean to take risk when investing? | Risk =possibility that you will not earn the return you expect. risk exists when an investment has more than one possible outcome. “good” risk greater returns than expected; “bad” risk lower returns than expected are possible. |
| How do u compute the risk and return of an investment, and explain how the risk and return of an investment are related | risk ass. w/ an invstmnt determined: measuring variability of returns,or average deviation from the expected return.standard deviation(σ ) |
| firm- specific | firm- specific (unsystematic) risk- caused by events unique to a firm and can be reduced or eliminated through diversification, |
| Describe actions that investors take when the return they require to purchase an in- vestment is different from the return they expect the investment to produce. | If investors require a return that exceeds expectd returns, they will not purchase the investment, or they will sell the investment if they already own it. ->lower the price of the investment-> incrs expected return. |
| Identify different types of risk and classify each as relevant or irrelevant with respect to determining an investment’s required rate of return. | firm-specific risks-unique to a firm;considered irrelevant when determining an investmnt’s required return. |
| risk | The chance that an outcome other than the expected one will occur. |
| probability distribution | A listing of all possible outcomes or events, with a probability (chance of occurrence) assigned to each outcome. |
| expected rate of return, rˆ | The rate of return expected to be realized from an investment; the mean value of the probability distribution of possible results. |
| standard deviation, σ | A measure of the tightness, or variability, of a set of outcomes. |
| coefficient of variation (CV) | A standardized measure of the risk per unit of return. It is calculated by dividing the standard deviation by the expected return. |
| risk aversion | Risk-averse investors require higher rates of return to invest in higher-risk securities. |
| risk premium (RP) | The portion of the expected return that can be attributed to the additional risk of an investment. the difference between the expected rate of return on a given risky asset and the expected rate of return on a less risky asset. |
| expected return on a portfolio, | The weighted average expected return on stocks held in a portfolio. |
| realized rate of return, ¨r | The return that is actually earned. The actual return (r¨) usually differs from the expected return (rˆ ). |
| Diversification | Reduction of stand- alone risk of an individual investment by combining it with other investments in a portfolio. |
| firm-specific (diversifiable) risk | That part of a security’s risk associated with random outcomes generated by events or behaviors, specific to the firm. can be eliminated by proper diversification. |
| market (nondiversifiable) risk | The part of a security’s risk associated with economic, or market, factors that systematically affect most firms. cannot be eliminated by diversification. |
| relevant risk | The portion of a security’s risk that cannot be diversified away; the security’s market risk. It reflects the security’s contribution to the risk of a portfolio. |
| capital asset pricing model (CAPM) | A model used to determine the required return on an asset, which is based on the proposition that any asset’s return should be equal to the risk-free return plus a risk premium that reflects the asset’s nondiversifiable risk. |
| security market line (SML) | The line that shows the relationship between risk as measured by beta and the required rate of return for individual securities. |
| market risk premium (RPM) | The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. |
| Equilibrium | The condition under which the expected return on a security is just equal to its required return, rˆ= r, and the price is stable. |
| standard deviation | standard deviation(σ )measures the scatter, or variability, of the possible outcomes for an investment; is a measure of the investment’s total, or stand-alone, risk, which is the risk an investor takes when holding an investment by itself. |
| market (systematic) risk | market (systematic) risk-stem from factors that affect the general economy; cannot be reduced through diversification. |
| Relevant risk | risk refers to the risk that investors must take; thus, the relevant risk for an investment is its systematic, or market, risk, because it cannot be eliminated. |
| relevant risk | Risks that affect all firms, generally through the economy, are considered relevant because they cannot be eliminated through diversification. These systematic factors represent the risks for which investors should be rewarded. |
Created by:
libqueen